Commodities Trading Technical Analysis and Expectancy

Fundamental analysis is a study of the factors that affect supply and demand - weather predictions and crop yields, new mines opened, new oil extraction technology, etc.

In contrast, technical analysis is based on the idea that trends can be detected by charting mathematical manipulations of a few basic variables: price, volume and a few others. Given much less weight in this type of analysis are most macro-economic factors. What is considered most important is actual market activity in the recent past, to predict future prices.

It is understood that any predictions can only be made with a limited degree of certainty. Only probable outcomes can be calculated. One variable – expectancy - gives technical analysis the edge.

Not used often enough by beginner traders, expectancy is a powerful trading tool and is simple to understand and calculate.

Expectancy = (Probability of Win * Average Win) - (Probability of Loss * Average Loss)

Imagine that an investor has enjoyed profitable trades for only 30% of the time for the last year, and the average trade profit was 10%. Losses were on average 3% of the amount invested, $10,000. Therefore:

Average profit = 0.10 x $10,000 = $1,000

Average loss = 0.03 x $10,000 = $300

So,

E = (0.30 x $1,000) – (0.70 x $300) = $300 - $210 = $90.

Note that even though the percentage of losing trades (70%) far outweighed winning trades, the trader still sees a net profit of $90 for the year. Not huge, but still not a loss.

In principle of course, the numbers could be anything. It is important to remember that coming out ahead in the long term is the point of using expectancy.

Psychologically, new traders tend to focus on the number of times trades were profitable vs those that resulted in losses. Expectancy helps you focus on the important item: net profits over time.

Whether to trade long term or short term is constantly being debated by stock traders. Non-professional day traders are often looked down on. But the situation in commodities is just the reverse. Generally short term positions, even for relatively inexperienced traders, lead to better results.

Accepting losses can be difficult for most non-professional traders. They often stay in the market too long, hoping for a turn around to eek out a profit, or at least minimize the loss. In many cases, with stocks, that will work out, but commodities are different.

Remember, the longer you stay tied to a position, the longer you have your capital tied up - capital that could be making you a profit that will more than compensate for past losses. To trade in commodities successfully, you need to realize that you cannot predict correctly 100% of the time.

Also, as most commodities trades are carried out by buying and selling futures or options contracts, you have a limited timeframe - generally no longer than a year and often much less - to make a decision. On average, the closer the contract gets to its expiration date, the more likely you are to lose.

Having a high risk factor and volatile price changes, commodities trading isn't for everyone. Research and the use of tools available mean that high profits are possible. A tool that should never be overlooked is expectancy. While other factors also have an impact, expectancy can help a commodities trader make the right decision at the right time.

         

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